The political economy of the euro crisis, part 1

Editor’s note: The is the first post following the post framework guidelines set out on April 8th. The intention is to write an in-depth analysis for Credit Writedowns Pro members, parts of which non-members can also access.

The European Union is an existential crisis because its crowning achievement, the single currency, has come under assault from all sides. The continued existence of the Euro has even been called into question as country after country within the euro zone has been forced into bailouts and austerity. The heart of the problem, as elsewhere in the industrialized world, stems from the unseemly growth in private credit that preceded the financial crisis in 2008 and the private debt overhang that accompanied that credit growth, even in the aftermath of extensive asset price deflation. Put simply, many private sector households and businesses across the industrialized world are upside down, in negative equity, bust by common definitions of balance sheet solvency. And the result has been and continues to be crisis.

The only legitimate question in this crisis is who is going to take the losses. That’s it. That is what this crisis is about and all of the crisis summit proclamations, restructurings, private sector involvement, bail-ins and defaults are just different ways of  carving up the losses.  

The problem is that, in the euro area, the toxic combination of high private debt and imploding asset prices is especially pernicious because of the limited policy space the euro affords countries with these problems. There is no money tree; the European central bank is not permitted to fund national governments. What’s more, natonal governments themselves are really not supposed to fund private sector losses either. The 3/60 deficit and debt hurdles of the Maastricht Treaty prevent this. So the tried and true method of deficit spending to reflate the economies is not on the agenda.  This leaves euro area countries with limited options, which certainly include bank nationalization. However, given the lack of central bank support these governments have, we now see this loss socialization route to reducing private indebtedness is pernicious indeed.

As I argued two years ago, the attempt by governments to maintain the excess credit by socializing the private debt problem onto government instead of writing down the losses would be the origins of the next crisis. And so it is. The euro zone is particularly vulnerable here because of the policy space limitations. And this is why we have a euro crisis, one that will continue for some time.

Below I want to set out a framework to examine the economic and policy constraints and the likely outcomes to this problem.

Let’s get started. 

The Political Economy of Crisis 

Back in 2008 and 2009, during the US crisis, I used to think I had a voice that had some influence. Time disabused me of this notion. So where I would sometimes write policy advocacy pieces, I don’t now. My focus is strictly on understanding the macro picture and how it impacts markets and the economy. So, this is NOT about policy advocacy.  It is about understanding the macro constraints, identifying likely policy outcomes and their economic and market impact and then iterating based on the actual policy responses and market and economic outcomes.

My macro view is a bit idiosyncratic as it has a heavy political economy base owing to my prior life as a diplomat and foreign policy wonk. This post is actually an iteration of a post from 2011 I called “The political economy of the European sovereign debt crisis“. And I have updated the title to reflect the fact that we are now in the banking and currency crisis portion of the euro crisis more than just the sovereign bit. As I explained in that 2011 post, when I think of political economic systems like the European Union or the euro zone, I believe that the status quo is relatively stable, as these are large hierarchical systems that benefit from lots of built-in stabilizers – economic, political, social and psychological. So, we would need to see an absolute collapse politically, socially and economically for a new status quo to arise. For example, you saw this kind of change in Germany after the Hyperinflation in the 1920s and in Italy just after World War I due to tremendous ruptures in the social and political consensus after an economic collapse. Things are bad in Europe but we are not there yet.

I take a fairly cynical view as to how these phase shifts occur in that I believe large hierarchical economic systems are all inherently unequal and that necessarily opens them to some level of kleptocracy, meaning that social, economic and political elites use the levers of power to tilt the balance of spoils in their favour. And so while revolutions usually begin with noble aims, they always do end with one strata of society enriching itself. The question is the level of self-enrichment.  The credit crisis has brought into view how much economic elites have enriched themselves during the boom time. And rather than letting the pendulum swing in the other direction, ‘elites’ have attempted to socialize losses. This has been mostly ineffective, particularly in the euro zone where no state is monetarily sovereign. And so the crisis has come to the euro zone first. However, we should be clear that all sovereign and non-sovereign debtors that are unwilling or unable to print money will face the same choices as Europe.

Now that the crisis has been visited upon Europe, however, let’s think about the euro crisis in the context of the psychology of change. What happens in a big crisis is that a rapid phase shift in the economic situation occurs that is incompatible with the prevailing orthodox economic paradigm. Large hierarchical systems always react by downplaying the phase shift. This is what we saw in 2007 in the US and again in 2009 in Europe. But the economics swamp the system’s ability to fix the problem within the existing paradigm and crisis ensues. In crisis, the move to reality-based context-oriented solutions is always incremental, meaning policy makers are going to be anchored by past decisions and prevailing economic paradigms and will only shift to the exigencies of the situation as required. And that means you get what I would call ‘ad-hocism’, which is what happens when markets call policy makers’ bluffs time and again and force a contextual solution outside of the prevailing economic dogma, requiring a shift in policy stance.

Economic Constraints

Before I get into the history of the euro crisis and the likely policy decisions, I want to set up a brief outline of the economic constraints the euro zone is labouring under. Look at all of these constraints as flexible, but to varying degrees. Institutional arrangements and economic dogma mean that these constraints are not easily overcome.

First, and most importantly, the euro area is a fixed exchange rate regime that is essentially like a gold standard in which the euro acts like gold and the euro area governments have fixed their national currencies to it at a specific exchange rate. Before the euro was introduced, this was indeed the arrangement: identical to the gold standard within the future euro area in every way. Then, the euro was introduced and the euro area economies were ‘euroized’, meaning that they lost currency sovereignty completely. There could be no devaluation and no money printing in the case of an economic crisis. During the Great Depression, during the competitive currency devaluation stage of the crisis, countries which dropped their gold peg first were the ones to recover the quickest. Countries, like the Netherlands, which adhered to the standard, suffered the most. It is similar today: the reason the euro crisis is so severe is because the euro acts like a gold standard, but without any possibility of the external currency devaluations of the 1930s. All internal and external imbalances must be corrected via a deflationary route. This is why the euro area is under-performing all other economic regions around the globe in terms of unemployment and economic growth.

Additionally, the euro area set up a set of deficit and debt guidelines in the Maastricht Treaty in 1992 that are proving to be pro-cyclical. The goal is to limit deficits in any given year to 3% of GDP and to limit overall government debt to 60% of GDP. And while there is wiggle room in how these measures have been applied, the goal is still there and that necessarily means cutting government spending or raising taxes. This austerity adds an extra hurdle for the private sector to overcome. Since recessions are a period of private sector retrenchment, the government retrenchment sucks even more money out of the private sector, increasing the severity of the economic trough. In worst case scenarios, as in Greece and Spain, this can trigger debt deflation whereby private debt defaults act as dominos by reducing the income of creditors and triggering their retrenchment and default, triggering yet more retrenchment and default down the line.

In the euro area, there is no federal body to pick up any slack when member states retrench. This was a known flaw right from the outset. British economist Wynne Godley presciently predicted when the Maastricht Treaty was developed in 1992 that the institutional arrangement without a counter-cyclical spending agent would lead to disaster. And it has done. In other currency areas like the United Kingdom, the federal government can serve as the countercyclical force such that local economic pain can be alleviated not just by outmigration and depression, but also via transfers to boost income at cyclical troughs. In the euro area by contrast, all of these commitments still fall on national governments who are also constrained by the Maastricht debt and deficit criteria and the threat of insolvency because of their status as users of currency without a lender of last resort.

And this lender of last resort question is an important one because this is the desired institutional arrangement for the euro area to prevent the euro from becoming a weak currency. The European central bank is to remain independent by official EU law. And in defense of the ECB, I would add that central bankers want elected officials to make the tough decisions about how and where to support economic growth. However, the severity of the crisis has caused the ECB to fudge this principle against great resistance in Germany in particular. The ECB fudged it once in late 2011 when Italy went to the wall and again in 2012 when Spain went to the wall.

Those are the hard economic policy constraints. Some other economic constraints come into play as well. One has been a feature in the news of late because the ECB released a household finance and consumption survey (PDF here) which showed considerable household wealth in Italy and Spain and less in Germany and the Netherlands. This is counterintuitive since Germany and the Netherlands are wealthy countries, have high per capita income and are the creditor countries conducting the bailouts in the periphery. One might ask why are the core countries bailing out the periphery then. Much of this owes to the financial sector balances of an economy. In Italy, the public sector is highly indebted but the private sector is relatively more wealthy as a result. In Spain, 90% of the private wealth is associated with ownership of residential property, a now depreciating asset class. In Germany, by contrast, rates of home ownership are low. And in the Netherlands, mortgage debt is extremely high at over 250% of GDP. These facts explain the differences. But what is implied here then is that the public sector’s cumulative deficits are really the non-public sector’s cumulative surpluses. And so the reason for these differences lie in how each country’s net financial assets is distributed. 

Then there is the question of bank size and solvency. This is particularly relevant in Spain given the depreciation of residential property assets on bank balance sheets. In Europe, there is at present no banking union that has a European-wide regulator and deposit guarantee scheme to oversee cases of bank insolvency and resolution. This falls on the state. However, if the size of the banking sector is too large relative to the government’s balance sheet you have a problem. This was a big takeaway from the fiasco in Iceland. But the same too big to rescue problem exists in many places across the euro area and outside the euro area – in places like Switzerland, the UK and Denmark. The Swiss have solved their problem by reducing the ability of their banking behemoths to take on risk and greatly increasing capital requirements. Meanwhile in Euroland, a crisis is brewing. The bank – sovereign nexus came to a head in Spain last year as the potential bailout of the bank sector is what precipitated the problems for Spanish sovereign debt. And the bank deposit grab in Cyprus was a direct result of the attempt by Europe to break this nexus by having private creditors take losses instead of the sovereign. Slovenia is the next problem child which is facing these issues.

And I should point out all of these issues have come to a head not just because of the lack of banking union but because of a centralized interest rate policy in Europe that dovetailed with vastly different macro economic conditions across the euro zone. While Spain and Ireland saw negative real interest rates which helped spawn property bubbles during the 2000s, Germany’s interest rates were aways positive in real terms, keeping a lid on interest-rate based leveraged speculation. Now that interest rates are exceedingly low in Euroland and elsewhere, talk of housing bubbles are everywhere in places they previously were not, Germany and Austria, Switzerland (link in German), Finland and Sweden. I believe this talk of bubbles is appropriate because I believe we will likely see asset price deflation in some of these economies at some point down the line when credit growth wanes. And then the macro imbalances will shift yet again. The euro zone will not be able to cope with that shift given the present institutional arrangements.

None of these debt problems are unknown. They are waiting for the prop of spending to fall so they can re-assert themselves. The same is true for US.

Now, I had intended to write this in one part, but the post got to be too long and so I am cutting it off here and will conclude in part two with some history of the crisis, policy choices, and likely policy, market and economic outcomes. Since this is the first in a series of these new weekly templates, bear with me as I settle on a format!